Cost of Capital Solutions

Cost of Capital - Solutions
1.
When calculating a WACC for a company with preferred stock, there is no need to
adjust the cost of the preferred stock to reflect the tax exclusion of 70% of the
preferred stock dividend.
A.
B.
2.
A firm can only have one break point in its marginal cost of capital curve, which will
occur when they deplete their additions to retained earnings and must switch over to
new issues of equity.
A.
B.
True
False
True
False
3.
Because creditors can foresee, to at least some extent, the costs of bankruptcy, they
charge a higher rate of interest to compensate for the present value of bankruptcy costs.
A.
B.
4.
Increasing a companys debt ratio will typically reduce the marginal cost of both debt and
equity financing; however, it still may raise the companys WACC.
*
5.
*
6.
*
7.
A.
B.
True
False
True
False
Although quite rare, the mathematics is such that the after-tax component cost of debt
financing can be greater than the after-tax component cost of equity financing.
A.
B.
True
False
The cost to the firm of retained earnings is zero, since they are generated from the
current earnings of the firm and there are no flotation costs associated with their
retention.
A.
B.
True
False
If we assume that the stock market is efficient, and if we assume that Stock A has a beta
of 1.20, while Stock B has a beta of 1.40 (that is, B has higher risk than A), then we must
also assume that the required rate of return on Stock B exceeds the required rate of
return on Stock A.
Old Exam Questions - Cost of Capital - Solutions
Page 1 of 42 Pages
A.
B.
8.
If a firm must pay flotation expense when issuing a security, then the firms required rate
of return on that security will be greater than the investors required rate of return for that
security.
A.
B.
9.
The easiest way to correctly calculate the firms cost of debt is simply to multiply the
coupon rate on the debt times one minus the firms tax rate.
*
10.
*
11.
*
12.
A.
B.
True
False
True
False
True
False
The cost of equity capital from the sale of new common stock (re) is generally equal to
the cost of equity capital from retention of earnings (rs), divided by one minus the
flotation cost as a percentage of sales price (1 - F).
A.
B.
True
False
If expectations for long-term inflation rose, but the slope of the SML remained constant,
this, for most firms, would have a greater impact on the required rate of return on equity,
rs, than on the interest rate on long-term debt, rd. In other words, the percentage point
increase in the cost of equity would be greater than the increase in the interest rate on
long-term debt. (Hint: play with some numbers and see what happens.)
A.
B.
True
False
If the tax laws stated that $0.50 out of every $1.00 of interest paid by a corporation
was allowed as a tax-deductible expense, it would probably encourage companies to
use more debt financing than they presently do, other things held constant.
A.
B.
True
False
1.
Which of the following statements is not (or least) correct?
A.
Because of the tax shelter created by issuing preferred stock dividends

(remember that 70 percent of dividends are excluded from taxes), the firms
Page 2 of 42 Pages
B.
C.
D.
E.
after-tax cost of preferred stock may be significantly less than its before-tax
cost.
The weighted average cost of embedded/historical capital (capital already
raised by the firm) will have little significance when the firm looks at taking on
new projects that will require them to issue additional capital.
Assume that a firm is comprised of two divisions that differ significantly in risk
and, therefore, in terms of their divisional screening rates. If the firm evaluates
all investments by using a weighted average corporate cost of capital (rather
than using divisional screening rates), the firm is likely to become more risky by
taking on more of the higher-risk projects and become less valuable by taking
on projects that earn a rate of return that is less than what they should be
earned based on the actual risk of the project.
Flotation costs may not be a significant factor for a firms bonds, since many
bond issues are privately placed (sold to institutional investors) with minimal
administrative expense. That is, the firm essentially nets what the institutional
investor pays.
Flotation costs may be a significant factor when a firm issues new shares of
common stock. If so, the firms cost of equity (new issues of common stock)
will be higher than the firms cost of retained earnings, but the firms cost of
retained earnings will still be equal to the investors required rate of return on
the firms common stock.
2.
If a U.S. company with two divisions, one very risky and the other with significantly less
risky, uses the same corporate discount rate to evaluate all projects, the most likely
outcome, as discussed in class, is that the firm will become:
A.
B.
C.
D.
E.
3.
A firm is considering the purchase of an asset whose risk is greater than the current
risk of the firm, based on any method for assessing risk. In evaluating this asset, the
decision maker should:
A.
B.
C.
D.
Riskier over time, and its value will decline.

Riskier over time, and its value will rise.
Less risky over time, and its value will rise.
Less risky over time, and its value will decline.
There is no reason to expect its risk position or value to change over time as a
result of its use of a single discount rate.
Increase the IRR of the asset to reflect the greater risk.

Increase the NPV of the asset to reflect the greater risk.
Reject the asset, since its acceptance would increase the risk of the firm.
Ignore the risk differential if the asset to be accepted would comprise only a
small fraction of the total assets of the firm.
Increase the cost of capital used to evaluate the project to reflect the higher risk
of the project.
E.
4.
Select the statement that is most correct.
Page 3 of 42 Pages
A.
B.
*
C.
D.
E.
5.

A.
B.
C.
D.
E.
6.
B.
C.
D.
E.
7.
When a bonds coupon rate is greater than its yield to maturity, the coupon rate
should be used as the firms before-tax cost of debt.
All other things equal (including component costs), a higher tax rate will lower a
firms WACC only if the firm uses debt financing.
While higher-than-average risk projects require discounting cash flows at a rate
above the firms WACC, it is usually not appropriate to discount lower-thanaverage risk projects at a rate below the firms WACC.
Even if project risks vary widely within a firm, a projects cash flows should
always be discounted at the corporate cost of capital (WACC).
Because of the sheer size of large, publicly traded firms, it is more difficult to
use the CAPM to estimate their cost of equity than to estimate it for small,
privately held firms.
Which of the following statements is most correct?

A.
Since most stock is privately placed, a firms required rate of return for a new
issue of common stock will be equal to the investors required rate of return for
that same issue.
The WACC represents the historical cost of capital and is usually calculated on
a before-tax basis.
When calculating the cost of debt, a company needs to adjust for taxes,
because interest payments are tax deductible.
Since the money is readily available, the cost of retained earnings is usually a
lot cheaper than the cost of debt financing.
When calculating the cost of preferred stock, a company needs to adjust for
taxes, because preferred stock dividends are tax deductible.
An increase in the corporate tax rate, all other factors held constant, should
lead to an increase in a firms weighted average cost of capital.
A firm can lower its component cost of debt simply by issuing debt with a lower
coupon rate.
The enterprise value of the firm can be found by taking the free cash flow
available to all investors and discounting it at the firms weighted average cost
of capital.
Since most equity is privately placed for publicly traded corporations, flotation
costs are negligible, and the firms cost of a new issue of common stock will be,
therefore, essentially the same as the investors required rate of return.
Since the market value of the firms debt and equity will continuously change
throughout the day, and since the firms book value of debt and equity is much
more stable over time, the firm should use book value weight to define its
optimal capital structure.
Which of the following statements is most correct?
Page 4 of 42 Pages
A.
B.
C.
D.
E.
8.
If a companys tax rate increases but the yield to maturity of its noncallable
bonds remains the same, then, all other factors held constant, the firms WACC
should decrease.
If the beta of a companys equity decreases, then, even when flotation costs
have been accounted for, it is possible for a company to achieve a lower
WACC by issuing new shares of common stock to meet its equity needs, rather
than relying upon retained earnings to meet those needs.
Typically, the before-tax cost of debt financing exceeds the after-tax cost of
equity financing.
Since the firm retains any earnings that are not needed to be paid out as
dividends, the cost of retained earnings is usually much cheaper that the cost
of debt financing.
All of the statements above are incorrect.
Which of the following statements is correct (most correct)?

A.
B.
C.
D.
Since there are no flotation costs associated with it, the cost of retained
earnings will always be less than the after-tax cost of debt financing.
When calculating the cost of preferred stock, a company needs to adjust for
taxes, because preferred stock dividends are tax deductible for the issuing firm.
If a companys tax rate increases then, all else equal, the companys weighted
average cost of capital will also increase.
A decrease in the risk-free rate, all else equal, will likely increase the marginal
costs of both debt and equity securities.
A companys targeted capital structure will affect its cost of capital. Changes
from the target may cause the weighted average cost of capital to either
increase or decrease.
E.
9.

A.
B.
C.
D.
The before-tax cost of debt, which is lower than the after-tax cost, is used as
the component cost of debt for purposes of developing the firm's WACC.
The total return on a share of stock refers to the dividend yield less any
commissions paid when the stock is purchased and sold.
The cost of issuing preferred stock by a corporation must be adjusted to an
after-tax figure because of the 70 percent dividend exclusion provision for
corporations holding other corporations' preferred stock.
The cost of equity raised by retaining earnings can be less than, equal to, or
greater than the cost of external equity raised by selling new issues of common
stock, depending on tax rates, flotation costs, the attitude of investors, and
other factors.
The component costs of capital are market-determined variables in as much as
they are based on investors' required returns.
E.
1.
Assume that a firm takes on a project that requires an initial investment in Year 0 of
$20,000. Also assume that the firm raised the $20,000 by issuing $6,000 of debt at a
Page 5 of 42 Pages
before-tax cost of debt of 5%, and issued $14,000 of equity at a cost of equity of 10%.
If the tax rate is 40%, then what is the weighted average cost of capital (WACC) for
this project?
A.
B.
C.
D.
E.
8.3%
7.7%
8.1%
8.5%
7.9%
WACC = (.05)(1-.4)(30%) + (.10)(70%) = .009 + .07 = 7.9%

2.
Your firm has estimated that it will spend $10 million on new capital budgeting projects
during the coming year. You have been asked to calculate the appropriate cost of
capital to be used to analyze these projects and have collected the following
information:
Your firms targeted capital structure consists of 40 percent debt and 60 percent
common equity.
Your firm expects to add $4 million to retained earnings over the coming year that
can be used to support the $10 million in new projects.
The company has corporate bonds outstanding with an 8 percent annual coupon
that are trading at par.
New debt can be issued as a private placement (no flotation expense) and will
have the same level of risk as the firms current debt.
The companys tax rate is 40 percent.
The risk-free rate is 4 percent.
The market risk premium is 5 percent.
The stocks beta is 1.2.
The company expects to pay a dividend on its common stock of $2.20 per share
next year (D1).
The companys ROE is 10% and its dividend payout rate is 50%.
The current stock price (P0) is $44 per share.
If the firm issues new shares of common stock, they will sell for $44 per share, but
the firm will have to pay flotation expense of 10%.
Each of the projects to be taken on has the same degree of risk as the current
projects of the firm.
What is the WACC of the entire $10 million to be raised?

*
A.
B.
C.
D.
E.
7.678%
8.032%
8.319%
8.598%
8.712%
Breakdown:
Debt = ($10,000,000)(.40) = $4,000,000

Retained Earnings = $4,000,000
New Equity = ($10 - $4 - $4) = $2,000,000
40%
40%
20%
After-tax KD = (8%)(1-.40) = 4.8%
Page 6 of 42 Pages
KS = 0.04 + (0.05)(1.2) = 10%

Alternatively,
g = (0.10)(1 0.50) = 5%
KS = $2.20 / $44.00 + 0.05 = 0.05 + 0.05 = 10%
Ke = $2.20 / ($44.00)(1-0.10) + 0.05 = 10.56%
Therefore,
WACC = (4.8%)(0.40) + (10.0%)(0.40) + (10.56%)(0.20)
= 1.92% + 4.0% + 2.112% = 8.032%
3.
Your company plans to issue debt with an annual coupon rate of 8.5% (interest paid
semi-annually) and which will mature in 20 years at a par value of $1,000. Your firms
investment bankers have stated that the bonds can be sold publicly to investors at a
price of $980 per bond, but that the firm will be required to pay a flotation expense to
the investment bankers equal to 2% of this price. If the firm has a marginal corporate
tax rate of 35%, then what will be the firms after-tax cost on this new debt to be
issued?
A.
B.
C.
D.
E.
5.35%
5.50%
5.65%
5.80%
5.95%
Net Price = ($980) (1 - .02) = $960.40

N = 40
PV = -$960.40
PMT = ($85 / 2) = $42.50
FV = $1,000
Solve for I/YR = 4.464097130%
KD = (4.464097130) (2) = 8.928194260%
After-tax KD = (8.928194260) (1 0.35) = 5.803326269% = 5.80%
YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 4 - 5:
Your company's current market-valued capital structure, which is considered to be
optimal, is shown below:
Page 7 of 42 Pages
Debt
Preferred Stock
Equity
40%
10%
50%
In order to meet their expansion plans for next year, the company has decided to raise
$5,000,000. Net Income is expected to be $550,000 next year. However, preferred
stock dividends are expected to account for $50,000 of this profit. The common stock
dividend payout rate is 40% of the profit after the payment of preferred dividends. The
corporate tax rate is equal to 40%, and the before-tax costs of new financing are
estimated to be:
4.
Debt:
5% for the first $500,000 of new debt.

6% for up to an additional $1,000,000 of new debt.
Preferred:
8% for the first $500,000 of new preferred.

9% for up to an additional $500,000 of new preferred.
Equity:
12% for retained earnings.

13% for up to the first $2,000,000 of new common stock.
14% for up to an additional $2,000,000 of new common stock.
What is the weighted average cost of capital for the very first dollar to be raised?
A.
B.
C.
D.
E.
8.34%
8.72%
8.23%
8.00%
8.51%
After-tax Costs of Debt: 3.0%, 3.6%, and 4.2%

Debt
Preferred
RE
5.
40%
10%
50%
x 3.00
x 8.00
x 12.00
=
=
=
1.20%
0.80%
6.00%
8.00%
What is the weighted average cost of capital for the entire $5,000,000 to be raised for
the expansion?
A.
B.
C.
D
E.
8.34%
8.72%
8.23%
8.00%.
8.51%
RE = ($550,000 - $50,000)(1-.4) = $300,000

Page 8 of 42 Pages
There are several different ways to do this. One of them is below.

Debt
Debt
Debt
Preferred
RE
Equity
Equity
6.
$500/$5,000 = 10%
$1,000/$5,000 = 20%
$500/$5,000 = 10%
$500 = 10%
$300 = 6%
$2,000 = 40%
$200 = 4%
x
x
x
x
x
x
x
3.00
3.60
4.20
8.00
12.00
13.00
14.00
=
=
=
=
=
=
=
0.30%
0.72%
0.42%
0.80%
0.72%
5.20%
0.56%
8.72%
A firms optimal capital structure consists of 40 percent debt, 10 percent preferred

stock, and 50 percent common stock. Assume that the firms before-tax cost of debt is
8 percent and that its tax rate is 40 percent. Also assume that the firms cost of
preferred stock is 10 percent and that its cost of common stock is 15 percent.
Calculate the firms weighted average cost of capital (WACC).
A.
B.
C.
D.
E.
10.72%
10.42%
10.52%
10.82%
10.62%
WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS)

WACC = (.08)(1-.4)(.40) + (.10)(.10) + (.15)(.50) = 0.0192 + 0.01 + 0.075 = 10.42%
7.
A firms optimal capital structure consists of 35 percent debt, 5 percent preferred stock,
and 60 percent common stock. Assume that the firms before-tax cost of debt is 6
percent and that its tax rate is 40 percent. Also assume that the firms cost of
preferred stock is 7 percent and that its cost of common stock is 11 percent. Calculate
the firms weighted average cost of capital (WACC).
A.
B.
C.
D.
E.
7.67%
8.52%
8.21%
7.89%
8.93%

WACC = (.06)(1-.4)(.35) + (.07)(.05) + (.11)(.60) = 0.0126 + 0.0035 + 0.066
WACC = 8.21%
Page 9 of 42 Pages
8.
information:
common equity.
Your firm expects to add $2.7 million to retained earnings over the coming year
that can be used to support the $9 million in new projects.
The company has corporate bonds outstanding with a 6 percent annual coupon
that are trading at par.
next year (D1).
the firm will have to pay flotation expense of 12.5%.
A.
B.
C.
D.
E.
7.81%
8.41%
8.21%
8.61%
8.01%
Breakdown:
Debt = ($9,000,000)(.35) = $3,150,000

New Equity = ($9 - $3.15 - $2.7) = $3,150,000
35%
30%
35%
After-tax KD = (6%)(1-.40) = 3.6%

KS = 0.03 + (0.05)(1.4) = 10%
Alternatively,
g = (0.10)(1 0.50) = 5%
KS = $1.50 / $30.00 + 0.05 = 0.05 + 0.05 = 10%
Ke = $1.50 / ($30.00)(1-0.125) + 0.05 = 10.71%
Therefore,
Page 10 of 42 Pages
WACC = (3.6%)(0.35) + (10.0%)(0.30) + (10.71%)(0.35)

= 1.26% + 3.0% + 3.7485% = 8.01%
9.
A firms optimal capital structure consists of 35 percent debt, 5 percent preferred stock,
and 60 percent common stock. Assume that the firms before-tax cost of debt is 7
percent and that its tax rate is 40 percent. Also assume that the firms cost of
preferred stock is 10 percent and that its weighted average cost of capital is 10.52%.
Calculate the firms cost of stock (equity).
A.
B.
C.
D.
E.
14.50%
14.25%
15.00%
14.00%
14.75%

WACC = (.07)(1-.4)(.35) + (.10)(.05) + (KS)(.60) = 10.52%
WACC = .0147 + .005 + (KS)(.60) = 10.52%
KS = (.1052 - .0147 - .005) / (.60) = .0855 / .60 = 14.25%
YOU ARE GIVEN THE FOLLOWING INFORMATION FOR PROBLEMS 10 - 11:
Debt
Preferred Stock
Equity
30%
10%
60%
$10,000,000. Net Income is expected to be $1,000,000 next year. However, preferred
estimated to be:
Debt:
4% for the first $2,000,000 of new debt.

Preferred:
6% for the first $1,000,000 of new preferred.

7% for up to an additional $1,000,000 of new preferred.
Equity:
Page 11 of 42 Pages

10.
What is the weighted average cost of capital for the very last dollar to be raised?
A.
B.
C.
D.
E.
9.60%
9.20%
9.40%
9.50%
9.30%
Debt = (.30)($10,000,000) = $3,000,000

Preferred = (.10)($10,000,000) = $1,000,000
Equity = (.60)($10,000,000) = $6,000,000
Additions to Retained Earnings = ($1,000,000 - $100,000)(1 - .4) = $540,000
Costs for very last dollar: Debt (3.0%); Preferred (6%); Equity (13%)
Debt
Preferred
RE
11.
30%
10%
60%
x 3.00
x 6.00
x 13.00
=
=
=
0.90%
0.60%
7.80%
9.30%
What is the weighted average cost of capital for the entire $10,000,000 to be raised for
the expansion?
A.
B.
C.
D
E.
7.918%
8.318%
8.418%
8.118%
8.218%
Additions to Retained Earnings = ($1,000,000 - $100,000)(1 - .4) = $540,000

Debt
Debt
Preferred
RE
Equity
Equity
Equity
$2,000,000
$1,000,000
$1,000,000
$540,000
$2,000,000
$2,000,000
$1,460,000
=
=
=
=
=
=
=
20.0%
10.0%
10.0%
5.4%
20.0%
20.0%
14.6%
x
x
x
x
x
x
x
2.40
3.00
6.00
10.00
11.00
12.00
13.00
=
=
=
=
=
=
=
0.480%
0.300%
0.600%
0.540%
2.200%
2.400%
1.898%
8.418%
Page 12 of 42 Pages
12.
Your companys stock currently has a price of $50 per share and is expected to pay a
year-end dividend of $4.00 per share (D1 = $4.00). The dividend is expected to grow
at a constant rate of 6 percent per year. The company has insufficient retained
earnings to fund capital projects and must, therefore, issue new common stock. The
new stock has an estimated flotation cost of $7 per share. Determine the company's
cost of equity capital.
A.
B.
C.
D.
E.
15.30%
14.90%
15.10%
15.70%
15.50%
Ke = D1/(P0 - F) + g = $4.00/($50 - $7) + 6% = $4.00/$43 + 6% = 9.30% + 6% =

15.30%
13.
Your companys CFO is interested in estimating the company's weighted average cots
of capital (WACC) and has collected the following information:
The company has bonds outstanding that mature in 18 years with an annual
coupon of 7.5 percent (the bond pays $75 on an annual basis). The bonds have a
face value of $1,000 and sell in the market today for $1,120, giving a before-tax
cost of debt of 6.36145%.
The risk-free rate is 3 percent
The market risk premium is 5 percent
The stock's beta is 1.2
The company's tax rate is 40 percent
The company's target capital structure consists of 60 percent equity and 40
percent debt
The company uses the CAPM to estimate the cost of equity and does not include
flotation costs as part of its cost of capital it uses the cost of retained earnings.
Determine the companys WACC.
A.
B.
C.
D.
E.
8.24%
7.39%
7.81%
6.47%
6.93%
Data given:
KRF = 3%
RPM = 5%
= 1.2
T = 40%
WD = 0.4
WS = 0.6
Step 1:
Determine the firm's costs of debt:
Page 13 of 42 Pages
N = 18, PV = -1,120, PMT = 75, FV = 1000, Solve for I/YR = KD = 6.36145%

Determine the firm's costs of equity:
KS = KRF + (RPM)() = 3% + (5%)1.2 = 9%
Step 2:
Given the firm's component costs of capital, calculate the firm's WACC:
WACC
14.
= WDKD(1 - T) + WSKS
= (0.4)(6.36145%)(1 - 0.4) + (0.6)(9%) = 1.53% + 5.4% = 6.93%
information:
common equity.
Your firm expects to add $3.0 million to retained earnings over the coming year that
The company has corporate bonds outstanding with a 7 percent annual coupon that
are trading at par.
New debt can be issued as a private placement (no flotation expense) and will have
the same level of risk as the firms current debt.
The company expects to pay a dividend on its common stock of $1.60 per share next
year (D1).
The current stock price (P0) is $22.86 per share.
If the firm issues new shares of common stock, they will sell for $22.50 per share (a
slight discount from the current price), but the firm will have to pay flotation expense of
10.0% ($2.25) and will only net $20.25.
Each of the projects to be taken on has the same degree of risk as the current projects
of the firm.
A.
B.
C.
D.
E.
7.8825%
8.0825%
8.2825%
8.6825%
8.4825%
Breakdown:
Debt = ($8,000,000)(.40) = $3,200,000

New Equity = ($8.0 - $3.2 - $3.0) = $1,800,000
40.0%
37.5%
22.5%
After-tax KD = (7%)(1-.40) = 4.2%
Page 14 of 42 Pages
KS = 0.02 + (0.06)(1.5) = 11%

Alternatively,
g = (0.10)(1 - 0.60) = 4%
KS = $1.60 / $22.86 + 0.04 = 0.07 + 0.04 = 11%
Ke = $1.60 / ($22.50)(1-.10) + 0.04 = 11.90%
WACC = (4.2%)(0.40) + (11.0%)(0.375) + (11.90%)(0.225)
= 1.68% + 4.125% + 2.6775% = 8.4825%
15.
A stock analyst has obtained the following information about Z-Mart, a large retail
chain:
(1)
The company has noncallable bonds with 20 years maturity remaining and a
maturity value of $1,000. Interest is paid on an annual basis. The bonds have
a 12 percent annual coupon and currently sell at a price of $1,273.8564.
(2)
Over the past four years, the returns on the market and on Z-Mart were as
follows:
Year
2000
2001
2002
2003
(3)
Market
12.0%
17.2
- 3.8
20.0
Z-Mart
14.5%
22.2
- 7.5
24.0
The current risk-free rate is 6.35 percent, and the expected return on the
market is 11.35 percent. The company's tax rate is 35 percent.
The company anticipates that its proposed investment projects will be financed with 45
percent debt and 55 percent equity. Determine what the company's estimated
weighted average cost of capital (WACC) is. (Hint: you can use regression analysis to
find the beta of the firms equity.)
A.
B.
C.
D.
E.
9.12%
10.45%
9.86%
12.03%
11.24%
WACC = [(0.45)(KD)(1 - T)] + [(0.55)(KS)]

A.
Use bond information to solve for KD:

N = 20; PV = -1,273.8564; PMT = 120; FV = 1,000, Solve for KD = 9%
Page 15 of 42 Pages
B.
To solve for KS, we can use the SML equation, but we need to find beta. Using
Market and Z-Mart return information and a calculator's regression feature we
find b = 1.3585.
So Ks = 0.0635 + (0.1135 - 0.0635)(1.3585) = 0.1314 = 13.14%
C.
Plug these values into the WACC equation and solve:

WACC = [(0.45)(0.09)(1 - 0.35)] + [(0.55)(0.1314)]
=0.026325 + 0.07227 = 0.098595 = 9.86%
16.
A firm assumes that it can issue new, 15-year debt with a maturity value of $1,000 and
with an annual coupon rate of 8 percent, but where interest is paid semi-annually. If
the firm believes that it can net $781.99 from the sale of each bond after any related
flotation costs, and if the firms marginal tax rate is 38 percent, then what is the aftercost of debt to this firm?
A.
B.
C.
D.
E.
6.64%
6.73%
6.82%
6.91%
7.00%
Answer: C 6.82%
N = 30; PV = -781.99; PMT = 40; FV = 1,000; Solve for I/YR = 5.50%
Annual Nominal Rate = (2)(5.50%) = 11.0%
After-Tax Rate = (11.0%)(1 - .38) = 6.82%
17.
A firms common stock has just paid a dividend (D0) of $1.00 per share. This dividend
is expected to grow at a long-run constant growth rate of 15 percent and investors
require a 20 percent rate of return on this stock. If the firm issues new shares of stock
it assumes that they will sell for the same price that investors are willing to pay today,
but the firm will have to pay flotation costs equal to 15 percent of this price. If the
firms marginal tax rate is 38 percent, then what is the firms cost (their required rate of
return) for a new issue of common stock?
A.
B.
C.
D.
E.
20.32%
20.46%
20.60%
20.74%
20.88%
Answer: E 20.88%
Page 16 of 42 Pages
P0 = [($1.00)(1.15)] / [.20 - .15] = $23.00

Ke = [($1.00)(1.15)] / [($23.00)(1 - .15)] + 0.15 = [$1.15 / $19.55] + 0.15 = 20.88%
18.
A firm has a market-value balance sheet as indicated below. The firm assumes that it
can issue debt at a before-tax cost of 10 percent and has a marginal tax rate of 40
percent. The firm can meet their equity needs through additions to retained earnings
and investors currently require a 16 percent rate of return on stock. If the firm issue
preferred stock, it will pay a dividend of $15 per year, and although investors will be
willing to pay $165 for each share of preferred, the firm will only net $150 per share
after accounting for related flotation expenses. Given this data, what is the firms
weighted average cost of capital (or the marginal costs of capital for the first dollar to
be raised)?
Balance Sheet at Market Value (In Millions)
A.
B.
C.
D.
E.
Current Assets
Other Assets
Fixed Assets
$100.00
$50.00
$150.00
Total Assets
$300.00
Long-term Debt
Preferred Stock
Equity
Total Liabilities and
Equity
$75.00
$15.00
$210.00
$300.00
12.60%
12.80%
13.00%
13.20%
13.40%
Answer: D 13.20%
WD = $ 75/$300 = .25
WP = $ 15/$300 = .05
WE = $210/$300 = .70
KD = .10
KP = $15/$150 = .10
KE = .16
WACC = (.25)(.10)(1-.40) + (.05)(.10) + (.70)(.16) = .015 + .005 + .112 = 13.20%
19.
Your company finances its projects with 50 percent debt, 10 percent preferred stock,
and 40 percent common stock.
The company can issue bonds at a yield to maturity of 6.4 percent.

The cost of preferred stock is 7 percent.
The company's common stock currently sells for $25 a share.
Page 17 of 42 Pages
The company's dividend is currently $2.00 a share (D0 = $2.00), and is expected to
grow at a constant rate of 5 percent per year.
Assume that the flotation cost on debt and preferred stock is zero, and no new
stock will be issued.
Given this information, determine the companys weighted average cost of capital.
A.
B.
C.
D.
E.
8.474%
7.863%
9.015%
8.172%
8.759%
KS = [($2.00)(1.05) / $25] + .05 = 13.4%

WACC = (.064)(1-.34)(.50) + (.07)(.10) + (.134)(.40)
WACC = .02112 + .007 + .0536 = .08172 = 8.172%
20.
Assume that a company just paid a $1.50 per share dividend on its common stock (D0 =
$1.50), that the dividend is expected to grow at a constant rate of 8 percent per year,
and that investors require a 12 percent rate of return. Now assume that if the company
issues additional stock, it must pay its investment banker a flotation cost of $2.50 per
share. Given this information, determine the cost of new external equity, Ke.
A.
B.
C.
D.
E.
12.15%
12.59%
12.37%
12.48%
12.26%
P0 = [($1.50)(1.08)] / [.12 - .08] = $1.62 / .04 = $40.50

Net Price = $40.50 - $2.50 = $38.00
Ke = ($1.62 / $38.00) + 0.08 = 0.0426 + 0.08 = 12.26%
21.
Assume that a firms optimal capital structure consists of 30% debt at a before-tax cost
of debt (KD) of 6 percent, 10% preferred stock at a cost of preferred (KP) of 8 percent,
and 60% stock; that the firms tax rate is 40%; and that the firms weighted average
cost of capital is equal to 9.56 percent (assume retained earnings and ignore flotation
costs). Now assume that markets are in equilibrium (required rates are equal to
expected rates), that the current price (Year 0) of the firms constant growth stock is
$37.50, that the firm retains 80 percent of its earnings, and that its return on equity
(ROE) is 12.50%. Based on this information, determine the firms expected dividend
(D1) for the coming year.
Page 18 of 42 Pages
A.
B.
C.
D.
E.
$1.20
$1.10
$1.05
$1.15
$1.00

.0956 = (0.06)*(1-0.4)*(0.30) + (0.08)*(0.10) + (KS)*(0.60)
^
KS = (.0956 - 0.0108 + 0.0080) / .6 = 0.1280 = 12.80% = Ks

^
KS = (D1 / P0) + g
g = RB = (.125)*(.80) = 10%
^
KS = 0.1280 = (D1 / $37.50) + 0.10

D1 = (0.1280 - 0.10)*($37.50) = $1.05
22.
information:
Your firms targeted capital structure consists of 40 percent debt and 60

percent common equity.
Your firm expects to add $4 million to retained earnings over the coming year
The company has bonds outstanding that have 10 years until maturity, a
maturity value of $1,000, pay an annual coupon of $70 ($35 every six months),
and are currently priced at $1,074.39.
The company expects to pay a dividend on its common stock of $1.53 per
share next year (D1).
If the firm issues new shares of common stock, they will sell for $44 per share
in the market, and the firm will also have to pay flotation expense of 10%.
Based on this information, determine the WACC (MCC) for the very first dollar to be
raised.
Page 19 of 42 Pages
A.
8.51%
B.
9.99%
C.
9.25%
D.
8.88%
E.
9.62%
Determine YTM:
N = 20; PV = -1,074.39; PMT = 35; FV = 1,000; Solve for I/YR = 3.0 * 2 = 6.00% =
YTM
After-tax KD = (6%)(1-.40) = 3.6%
KS = 0.04 + (0.06)(1.4) = 12.40%
Alternatively,
g = (0.15)(1 - 0.40) = 9%
KS = $1.53 / $45.00 + 0.09 = 0.034 + 0.09 = 12.40%
Ke = $1.53 / ($44.00)(1 - 0.10) + 0.09 = 12.86% (Not needed for this problem.)
Therefore, for very first dollar:
WACC = (3.6%)(0.40) + (12.40%)(0.60) = 1.44% + 7.44% = 8.88%
23.
Assume that an all equity firm has a return on assets (ROA) of 12.80 percent. And that
the firm makes the decision to replace of its equity with debt that has a before-tax
cost of 8 percent (note: this will give a D/E ratio of ( / ) = 1/3 ). Assuming that the
firms tax rate is 40 percent, calculate the firms ROE after the debt has been issued
and equity has been repurchased.
A.
B.
C.
D.
E.
15.10%
15.47%
14.73%
15.84%
14.36%
AT KD = (8.00%)(1-.40) = 4.80%
As discussed in class, after the issue and repurchase, the remaining equity
shareholders will benefit from both a leverage effect and a tax shelter effect:
ROE = 12.80% + (12.80% - 8.00%)(1/3) + (8.00% - 4.80%)(1/3)
ROE = 12.80% + 1.60% + 1.07% = 15.47%
The following is an illustration with some numbers that were pulled from the air:
assets of $1,200, then working backwards from an ROA of 12.80% to get EBIT of
$256.00.
Page 20 of 42 Pages
Assets/Income
Without
Debt
Assets
Debt (1/4)
Equity
$1,200.00
$
0.00
$1,200.00
EBIT
Interest (8%)
EBT
Taxes (40%)
Net Income
ROA
ROE
24.
$
$
$
-$
$
With
Debt
$1,200.00
$ 300.00
$ 900.00
256.00
0.00
256.00
102.40
153.60
$ 256.00
- $ 24.00
$ 232.00
- $ 92.80
$ 139.20
12.80%
12.80%
11.60%
15.47%
Assume that a firms optimal capital structure consists of 30% debt at a before-tax cost
of debt (KD) of 6 percent, 10% preferred stock at a cost of preferred (KP) of 8 percent,
and 60% stock, and that the firms tax rate is 40%. Also assume that the firms
weighted average cost of capital is equal to 9.572 percent. Based on this information,
determine the firms cost of common stock (KS).
A.
B.
C.
D.
E.
12.49%
11.83%
12.16%
11.50%
12.82%

.09572 = (0.06)*(1-0.4)*(0.30) + (0.08)*(0.10) + (KS)*(0.60)
KS = (.09572 - 0.0108 + 0.0080) / .6 = 0.1282 = 12.82%
25.
Assume that an analyst has collected the following information about your company:
The companys capital structure consists entirely of debt and equity and the debt/equity
ratio is 2/3.
The yield to maturity on the companys debt is 6 percent.
The company pays out all of its earnings as dividends (retention rate of zero) and the
companys year-end dividend (D1) is forecasted to be $0.75 a share.
The company expects that its dividend will grow at a constant rate of 6 percent a year.
The companys stock price is $25.
The company will meet its equity requirements by issuing new common stock and they
anticipate that total flotation costs will be equal to 20 percent of the amount issued.
Page 21 of 42 Pages
Assume the company accounts for flotation costs by adjusting the cost of capital. Given
this information, determine the companys WACC.
A.
B.
C.
D.
E.
7.15%
6.87%
7.29%
7.01%
6.73%
Debt / Value = 2 / (2 + 3) = 40%

Equity / Value = 3 / (2 + 3) = 60%
KD = 6%
Ke = [$0.75 / ($25.00)*(1 - .20)] + .06 = $0.75 / $20.00 + .06 = 9.75%
WACC = (.06)*(1-.40)*(.4) + (.0975)*(.6) = 1.44% + 5.85% = 7.29%
26.
Assume that a firms optimal capital structure consists of 25 percent debt, 8 percent
preferred, and 67 percent equity, where the firm will have sufficient retained earnings
to meet its equity needs. The firms before tax cost of debt is 7 percent and its tax rate
is 40 percent. The price of the firms common stock is currently $45 per share, it
expects to pay a dividend of $3.15 next year, and its long-run sustainable growth is 6
percent. Given this information, and assuming that the firm has a weighted average
cost of capital (WACC) of 10.548 percent, determine the firms cost of preferred stock.
A.
B.
C.
D.
E.
10.14%
9.27%
9.85%
8.98%
9.56%
KS = ($3.15 / $45.00) + .06 = 13%

WACC = .10548 = (.07)*(1-.4)*(.25) + (KP)*(.08) + (.13)*(.67)
KP = (.10548 - .0105 - .0871) / (.08) = (.00788) / .08 = 9.85%
27.
Assume that a firm expects that its common stock dividend will be $1.90 next year
(D1). It also believes that if it sells new shares, the market will be willing to pay $37.50
per share, but that the firm would only net $33.00 per share after adjusting for flotation
costs. Given this data, and assuming that the firms long-run sustainable growth rate
is 6 percent, determine the firms cost of new equity.
A.
B.
11.52%
12.00%
Page 22 of 42 Pages
C.
D.
E.
11.04%
11.28%
11.76%
Ke = ($1.90 / $33.00) + 0.06 = 11.76%
28.
Assume that a firms optimal capital structure consists of $30,000,000 of debt at a

before-tax cost of debt (KD) of 8 percent, $10,000,000 of preferred stock at a cost of
preferred (KP) of 8 percent, and $60,000,000 of stock at a cost of stock (KS) of 14
percent. Assuming that the firms tax rate is 40%, determine the firms weighted
average cost of capital (WACC).
A.
B.
C.
D.
E.
10.34%
11.24%
10.94%
11.54%
10.64%

WD = $30,000,000 / $100,000,000 = 30%
WP = $10,000,000 / $100,000,000 = 10%
WS = $60,000,000 / $100,000,000 = 60%
WACC = (0.08)*(1-0.4)*(0.30) + (0.08)*(0.10) + (0.14)*(0.60)
WACC = 0.0144 + 0.008 + 0.084 = 0.1064 = 10.64%
29.

Debt
Preferred Stock
Equity
30%
20%
50%
$4,000,000. Net Income is expected to be $350,000 next year. However, preferred
estimated to be:
Debt:
4% for the first $500,000 of new debt.

Preferred:
8% for the first $500,000 of new preferred.
Page 23 of 42 Pages
9% for up to an additional $500,000 of new preferred.

Equity:

Given this information, determine the weighted average cost of capital for the entire
$4,000,000 to be raised for the expansion.
A.
B.
C.
D.
E.
9.65%
8.85%
9.45%
9.05%
9.25%
RE = ($350,000 - $50,000)(1-.35) = $195,000

Debt
Debt
Preferred
Preferred
RE
Equity
$500/$4,000 = 12.500%
$700/$4,000 = 17.500%
$500/$4,000 = 12.500%
$300/$4,000 = 7.500%
$195/$4,000 = 4.875%
$1,805/$4,000 = 45.125%
100.000%
x
x
x
x
x
x
2.40
3.00
8.00
9.00
13.00
14.00
=
=
=
=
=
=
0.30000%
0.52500%
1.00000%
0.67500%
0.63375%
6.31750%
9.45125%
WACC = 9.45%
30.
Assume that your firm has a weighted average cost of capital of 10.00%, and has a
capital structure consisting of 40 percent debt and 60 percent equity. Also assume that
the firms tax rate is 40 percent and that its cost of stock/equity (ignore flotation costs) is
14 percent. Given this information, determine the firms before-tax cost of debt.
A.
B.
C.
D.
E.
6.875%
6.500%
6.667%
6.125%
6.333%
WACC = 0.10 = (KD)(1-.40)(.40) + (.14)(.60)

KD = (0.10 - 0.084) / (1-.40)(.40) = 0.016 / 0.24 = 6.67%
Page 24 of 42 Pages
31.
Assume that your firm has a target capital structure of 30% debt and 70% common
stock, that the companys before-tax cost of debt is 6%, and that the marginal tax rate is
35%. Also assume that the current stock price (P0) is $30.00, that the dividend just paid
(D0) was $1.80, and that this dividend is expected to grow at a constant rate of 4%.
Given this information, and assuming that the firms equity needs can be financed from
additions to retained earnings, determine the firms weighted average cost of capital.
A.
B.
C.
D.
E.
8.58%
9.11%
8.72%
8.97%
8.34%
D1 = ($1.80)(1.04) = $1.872
KS = [($1.872) / ($30.00)] + 0.04 = 10.24%
WACC = (0.06)(1-.35)(.30) + (0.1024)(.70) = 0.0117 + 0.07168 = 0.08338 = 8.34%
32.
Assume that your firm can issue new common stock that will pay a dividend (D1) of
$2.50 next year, that this dividend will grow at a constant annual growth rate of 4%, and
that investors have a required rate of return of 10.25% (you should now be able to
determine the current price that investors should be willing to pay for this stock). Also
assume that the firm will pay flotation expense of 15 percent to its investment bankers.
Using the discounted cash flow (DCF) model, determine the firms required rate of return
on this newly issued equity.
A.
B.
C.
D.
E.
11.95%
11.75%
11.35%
11.55%
11.15%
P0 = ($2.50) / (0.1025 - 0.04) = $40.00

Ke = [$2.50) / ($40.00)(1-.15)] + 0.04 = [($2.50 / $34.00) + 0.04] = 11.35%
33.
Assume that a firm can issue preferred stock with a par value of $100 and paying an
annual preferred stock dividend of $12 per share. Investors will be willing to pay $150
per share, but the firm will only net $130 per share (after paying $20 of flotation expense
to its investment bankers). Given this information, determine by how much the firms
cost of this preferred stock exceeds the investors required rate of return on this
preferred stock.
A.
B.
C.
D.
E.
0.83%
1.63%
1.03%
1.23%
1.43%
Investors:
Page 25 of 42 Pages
KP = $12.00 / $150.00 = 0.0800

Firm:
KP = $12.00 / $130.00 = 0.0923
Difference = 0.0923 - 0.0800 = 0.0123 = 1.23%
34.
Assume that your company has an optimal capital structure that consists of 32 percent
equity and 68 percent debt. If the company expects to report $5 million in net income
this year, and 60 percent of the net income will be paid out as dividends, then
determine how large its capital budget may be before it will have to issue any new
common stock (external equity).
A.
B.
C.
D.
E.
$5.25
$6.00
$6.25
$5.50
$5.75
million
million
million
million
million
Addition to Retained Earnings = ($5,000,000)(1 - .60) = $2,000,000

Since equity = 32% of the capital budget, the capital budget can be:
$2,000,000 / .32 = $6,250,000 = $6.25 million before external equity has to be issued.
35.
Assume that your company finances its operations with 40 percent debt, 10 percent
preferred stock, and 50 percent equity. Also assume that the preferred stock pays an
annual dividend of $2 and sells for $20 a share, that the companys common stock
trades at $30 a share, that its current common stock dividend (D0) of $2 a share is
expected to grow at a constant rate of 8 percent per year, and that the flotation cost of
external equity is 15 percent of the dollar amount issued, while the flotation cost on
preferred stock is 20 percent. Now assume that the firms tax rate is 35 percent, that the
firm will not have enough retained earnings to fully fund the equity portion of its capital
budget, and that the marginal cost of capital for the last dollar to be raised is 12.75
percent. Determine the firms before-tax cost of debt financing.
A.
B.
C.
D.
E.
12.56%
11.66%
12.86%
12.26%
11.96%
KP = $2 / ($20)(1 - .20) = $2 / $16 = 12.50%

KS = [($2.00)(1.08) / $30.00] + .08 = 15.20%
Ke = [$2.00)(1.08) / ($30.00)(1 - .15) + .08 = 16.47%
MCC = 12.75% = (KD)(1-.35)(.40) + (12.50%)(.10) + (16.47%)(.50)
MCC = 12.75% = (KD)(.26) + (1.25%) + (8.235%)
Page 26 of 42 Pages
KD = (12.75% - 1.25% - 8.235%) / .26 = 3.265 / .26 = 12.56%

36.
Assume that the beta of an all equity firm is 0.9, that the risk-free rate is 6 percent, and
that the firms required rate of return (using CAPM) is 15 percent. If the firm changes
its capital structure to 25% debt and 75% equity, where the before-tax yield (cost) of
debt is 8.5%, and if the tax rate is 40%, then determine the firms new weighted
average cost of capital (WACC). (You may assume that the beta for debt is zero.)
A.
B.
C.
D.
E.
14.125%
13.625%
13.375%
13.125%
13.875%
Since the firm has a beta of 0.9,

KM must be equal to 16%: 15% = (.06) + (.16 - .06)(0.9)
New levered beta = 0.9 + (0.9)(.25/.75)(1 - .40) = 1.08
New equity required rate of return = .06 + (.16 - .06)(1.08) = 16.80%
WACC = (8.5)(1-.4)(.25) + (16.80)(.75) = 1.275 + 12.600 = 13.875%
37.
Your company is considering the following five independent projects:
Project
Cost
IRR
A
B
C
D
E
$300,000
$550,000
$400,000
$375,000
$325,000
19%
16%
14%
13%
11%
The company has a target capital structure that consists of 30 percent debt and 70
percent common equity. The company can issue bonds with a before-tax yield to
maturity of 8 percent. The company expects to add $350,000 to its retained earnings,
and the current stock price is $35 per share. The flotation costs associated with
issuing new equity are 12.5% of the market price. The companys earnings are
expected to continue to grow at 6 percent per year, next years dividend (D1) is
forecasted to be $2.45, and the firm faces a 40 percent tax rate. Given this
information, determine the size of the firms optimal capital budget.
A.
B.
$1,250,000
$ 300,000
Page 27 of 42 Pages
C.
D.
E.
$1,625,000
$ 850,000
$1,950,000
KD = (8.0%)(1-.4) = 4.8%
KS = [$2.45 / $35.00] + 6.0% = 13.0%
Ke = [$2.45 / ($35.00)(1 - .125)] + 6.0% = 14.0%
Firm will switch from KS to Ke when the capital budget hits $350,000 / .70 = $500,000
Below $500,000:
WACC = (4.8%)(.30) + (13.0%)(.70) = 1.44% + 9.10% = 10.54%
Above $500,000:
WACC = (4.8%)(.30) + (14.0%)(.70) = 1.44% + 9.80% = 11.24%
Therefore, the firm should take on Projects A-D and the size of the optimal capital
budget should be $1,625,000.
38.
An analyst has collected the following information regarding your company:
The companys capital structure is 75 percent equity, 25 percent debt.

The before-tax yield to maturity on the companys bonds is 8 percent and the
bonds are selling at par value.
The companys dividend next year is forecasted to be $1.25 a share.
The company expects that its dividend will grow at a constant rate of 6 percent
a year.
The company anticipates that it will need to raise new common stock this year.
Its investment bankers anticipate that the total flotation cost will equal 12.5
percent of the amount issued -- you may assume that the company accounts
for flotation costs by adjusting the component cost of capital.
Given this information, determine what the companys WACC will be when it is forced
to issue new shares of common stock.
A.
B.
C.
D.
E.
10.736%
9.914%
10.349%
9.627%
11.055%
Kd = 8% (given)
Ke = [D1 / P0(1 - F)] + g
Page 28 of 42 Pages
Ke = [$1.25 / $20(1 - 0.125)] + 0.06 = 13.14%

WACC = WdKd(1 - T) + WeKe
WACC = (0.25)(8.00%)(0.6) + (0.75)(13.14%) = 1.2% + 9.855% = 11.055%
39.
during the coming year and has collected the following information:
Your firms targeted capital structure consists of 40 percent debt, 10 percent

preferred, and 50 percent common equity.
The company has corporate bonds outstanding that have 10 years until maturity, a
face value of $1,000, a semi-annual coupon of $40, and a current price of $934.96.
New debt (at least $7 million) can be issued as a private placement (no flotation
expense) and will have the same level of risk as the firms current debt.
New preferred stock (at least $2 million) can be issued at a price of $100 per
share, but flotation costs will be 20 percent. This preferred stock will pay an annual
dividend of $9.60 per share.
next year (D1).
Given this information, determine the weighted average (marginal) cost of capital of
the very last dollar to be raised.
A.
B.
C.
D.
E.
11.062%
12.178%
11.620%
12.736%
10.504%
New Equity = ($10,000,000)*(.50) - $3,000,000 = $2,000,000

Find rD:
N = 20; PV = -934.36; PMT = 40; FV = 1,000; Solve for I/YR = (4.50)*(2) = 9.0%
After-tax rD = (9%)(1-.40) = 5.4%
Page 29 of 42 Pages
Find rP:
rP = $9.60 / ($100.00)*(1-.20) = $9.60 / $80.00 = 12.0%
Find rS and re:
rS = 0.04 + (0.08)(1.4) = 15.20%
Alternatively,
g = (0.20)(1 - 0.70) = 6%
rS = $2.76 / $30.00 + 0.06 = 0.092 + 0.06 = 15.2%
re = $2.76 / ($30.00)(1 - 0.125) + 0.06 = 16.51%
Therefore, for the very last dollar raised
WACC = (5.4%)(0.40) + (12.0%)(0.10) + (16.51%)(0.50)
= 2.16% + 1.2% + 8.26% = 11.62%
40.
Assume that a firms current capital structure consists of 1/3 debt and 2/3 common
stock (a debt/equity ratio of or 0.50). Assume that the firms before-tax cost of debt
is 6 percent, that its tax rate is 40 percent, and that its cost of common stock is 10
percent. Also assume that the risk-free rate is 4 percent and that the market risk
premium is 5 percent (you should now be able to calculate the firms levered beta).
Given this information, determine what the firms new weighted average cost of capital
will be if it changes to a capital structure of 50 percent debt and 50 percent equity (a
debt/equity ratio of 0.50/0.50 or 1.0)
A.
B.
C.
D.
E.
8.10%
6.90%
8.70%
7.50%
9.30%
Determine current levered beta:

10.0% = 4.0% + (5.0%)*(L)
L = (10.0% - 4.0%) / 5.0% = 1.20
Unlever beta:
U = (1.20) / (1 + (0.50)(1-.40)) = 0.923076923
Relever beta at new capital structure:
L = (0.923076923)*(1 + (1.0)*(1 - .40)) = 1.476923077 = 1.48
Page 30 of 42 Pages
Determine new rS = 4.0% + (5.0%)*(1.48) = 11.40%

Calculate new WACC:
WACC = (rD)(1-T)(rD) + (rS)(rS)
WACC = (.06)(1-.4)(.50) + (.114)(.50) = 0.018 + 0.057 = 7.50%
41.
Assume that a firm takes on a project that requires an initial investment in Year 0 of
$50,000. Also assume that the firm raised the $50,000 by issuing $10,000 of debt at a
before-tax cost of debt of 8%, and issued $40,000 of equity at a cost of equity of 15%.
Given this information, and assuming that the tax rate is 40%, determine the weighted
average cost of capital (WACC) for this project.
A.
B.
C.
D.
E.
11.44%
11.98%
12.96%
12.48%
10.92%
WACC = (.08)(1-.4)(20%) + (.15)(80%) = .0096 + .12 = 12.96%

42.
Assume that your firm has estimated that it will spend $20 million on new capital
budgeting projects during the coming year and that you have been asked to calculate
the appropriate cost of capital to be used to analyze these projects. You have
collected the following information:
common equity.
The company has corporate bonds outstanding with an 8 percent annual coupon that
are trading at par.
year (D1).
slight discount from the current price), and the firm will have to pay flotation expense of
10.0% ($2.75).
of the firm.
Page 31 of 42 Pages
Given this information, determine what the WACC/MCC will be for the very last dollar
(i.e., the $20,000,000th) to be raised.
A.
B.
C.
D.
E.
12.48%
10.32%
11.94%
10.86%
11.40%
Breakdown:
Debt = ($20,000,000)*(.40) = $8,000,000

Equity = ($20,000,000)*(.60) = $12,000,000
Since the firm only expects to add $5,000,000 to its retained earnings account, the
equity portion for the very last dollar to be raised must come from newly issued equity.
Therefore, we would have the following:
After-tax rD = (8%)(1-.40) = 4.8%
rS = 0.04 + (0.06)(1.6) = 13.6%
Alternatively,
g = (0.20)(1 - 0.70) = 6%
rS = $2.20 / $28.95 + 0.06 = 0.076 + 0.06 = 13.6%
re = $2.20 / ($27.50)(1-.10) + 0.06 = 0.089 + 0.06 = 14.90%
WACC = (4.8%)(0.40) + (14.9%)(0.60) = 1.92% + 8.94% = 10.86%
43.
Assume that your firm has just opened for business and that it was originally funded
with investor-supplied capital equal to $30,000,000: $12,000,000 by creditors who
required an 8 percent before-tax rate of return; and $18,000,000 by stockholders who
required a 15 percent rate of return. [Based on this information, and knowing that the
tax rate is 40 percent, you should be able to determine that the weighted average cost
of capital (WACC) for the firm is 10.92 percent.] Now assume that for all future years
the firm expects to make no additional investments in assets, that depreciation is zero,
and that its operations will produce sales of $40,000,000 and EBIT of $6,000,000.
[Given this information, you should now be able to calculate the free cash flow and/or
the economic value added for all future years, and from this and the WACC previously
determined, you should be able to calculate the enterprise value and/or market value
added (MVP or NPV).] Now, as demonstrated in class, and assuming that the WACC
remains constant at 10.92 percent, and that the before-tax cost of debt remains
constant at 8 percent, determine what the new cost of equity must be. (Hint: the
debt/value and equity/value ratios will change but the WACC will remain constant.)
A.
B.
C.
D.
12.44%
15.40%
11.48%
13.46%
Page 32 of 42 Pages
E.
14.42%
WACC = (.08)*(1-.4)*(.4) + (.15)*(.6) = 1.92% + 9.0% = 10.92 percent

NOPAT = FCF = ($6,000,000.00)*(1-.4) = $3,600,000.00
Enterprise Value = $3,600,000 / .1092 = $32,967,033
MV of Equity = $32,967,033 - $12,000,000 = $20,967,033
Debt/Value = $12,000,000 / $32,967,033 = 36.40%
Equity / Value = $20,967,033 / $32,967,033 = 63.60%
WACC = 10.92% = (.08)*(1-.4)*(.364) + (rS)*(.636)
rS = (10.92% - 1.7472%) / 0.636 = 14.422641509% = 14.42%
Alternatively,
EVA = $3,600,000 - ($30,000,000.00)*(.1092) = $324,000
MVA = NPV = $324,0000 / .1092 = $2,967,033
MV of Equity = $18,000,000 + $2,967,003 = $20,967,033
Enterprise Value = $12,000,000 + $20,967,003 = $32,967,033
Debt/Value = $12,000,000 / $32,967,033 = 36.40%
Equity / Value = $20,967,033 / $32,967,033 = 63.60%
WACC = 10.92% = (.08)*(1-.4)*(.364) + (rS)*(.636)
rS = (10.92% - 1.7472%) / 0.636 = 14.42%
Alternatively,
Interest = ($12,000,000)*(0.08) = $960,000
EBIT
Interest
EBT
Taxes
Net Income
$6,000,000
-$ 960,000
$5,040,000
-$2,016,000
$3,024,000
MV Equity = $20,967,033 = $3,024,000 / rS

rS = $3,024,000 / $20,967,033 = 14.42%
Page 33 of 42 Pages
44.
Your companys stock currently has a price of $40 per share and is expected to pay a
year-end dividend of $1.00 per share (D1 = $1.00). The dividend is expected to grow
at a constant rate of 6 percent per year. The company has insufficient retained
earnings to fund capital projects and must, therefore, issue new common stock. The
new stock has an estimated flotation cost of $5 per share. Determine the company's
cost of new equity capital.
A.
B.
C.
D.
E.
9.40%
8.59%
9.13%
9.67%
8.86%
In this case, F is in dollar form, not a percent of the stocks price:

re = D1/(P0 - F) + g = $1.00/($40 - $5) + 6% = $1.00/$35 + 6% = 2.86% + 6% = 8.86%
45.
during the coming year and has collected the following information:
Your firms targeted capital structure consists of 40 percent debt, 10 percent

preferred, and 50 percent common equity.
The company has corporate bonds outstanding that have 10 years until maturity, a
face value of $1,000, a semi-annual coupon of $40, and a current price of $934.96.
New debt (at least $7 million) can be issued as a private placement (no flotation
expense) and will have the same level of risk as the firms current debt.
New preferred stock (at least $2 million) can be issued at a price of $100 per
share, but flotation costs will be 20 percent. This preferred stock will pay an annual
dividend of $9.60 per share.
next year (D1).
Given this information, determine the weighted average (marginal) cost of capital of
the very first dollar to be raised.
*
A.
B.
C.
D.
10.96%
12.07%
11.33%
12.44%
Page 34 of 42 Pages
E.
11.70%
New Equity = ($10,000,000)*(.50) - $3,000,000 = $2,000,000

But not needed for the very first dollar, since RE will be used for equity.
Find rD:
N = 20; PV = -934.36; PMT = 40; FV = 1,000; Solve for I/YR = (4.50)*(2) = 9.0%
After-tax rD = (9%)(1-.40) = 5.4%
Find rP:
rP = $9.60 / ($100.00)*(1-.20) = $9.60 / $80.00 = 12.0%
Find rS and re:
rS = 0.04 + (0.08)(1.4) = 15.20%
Alternatively,
g = (0.20)(1 - 0.70) = 6%
rS = $2.76 / $30.00 + 0.06 = 0.092 + 0.06 = 15.2%
re = $2.76 / ($30.00)(1 - 0.125) + 0.06 = 16.51%
Therefore, for the very first dollar raised
WACC = (5.4%)(0.40) + (12.0%)(0.10) + (15.2%)(0.50)
= 2.16% + 1.2% + 7.6% = 10.96%
46.
Assume that a firms current capital structure consists of 50 percent debt and 50
percent common stock (a debt/equity ratio of 1.00). Assume that the firms before-tax
cost of debt is 6 percent, that its tax rate is 40 percent, and that its cost of common
stock is 11 percent. Also assume that the risk-free rate is 4 percent and that the
market risk premium is 5 percent (you should now be able to calculate the firms
levered beta). Given this information, determine what the firms new weighted average
cost of capital will be if it changes to a capital structure of 75 percent debt and 25
percent equity.
A.
B.
C.
D.
E.
6.1900%
7.9075%
6.7625%
8.4800%
7.3350%
Determine current levered beta:

Page 35 of 42 Pages
11.0% = 4.0% + (5.0%)*(L)

L = (11.0% - 4.0%) / 5.0% = 1.40
Unlever beta:
U = (1.40) / (1 + (1.00)(1-.40)) = 0.875
Relever beta at new capital structure:
L = (0.875)*(1 + (3.0)*(1 - .40)) = 2.45
Determine new rS = 4.0% + (5.0%)*(2.45) = 16.25%
Calculate new WACC:
WACC = (rD)(1-T)(rD) + (rS)(rS)
WACC = (.06)(1-.4)(.75) + (.1625)(.25) = 0.027 + 0.040625 = 6.7625%
47.
Assume that the risk-free rate is 5 percent, the return on the market is 12 percent, and
that a firm has a debt/value ratio of 1/3, an equity/value ratio of 2/3, a before-tax cost
of debt of 8 percent, a cost of equity of 15 percent, and a tax rate of 40 percent.
(HINT: you should now be able to calculate its WACC and back out its levered and
unlevered beta.) Now assume that the firm intends to double its debt and use the
proceeds to buy back its stock (the debt/value and equity/value ratios will each now be
2/3 and 1/3 respectively). Using the Hamada equations to relever beta, determine
what the firms new cost of equity will be.
A.
B.
C.
D.
E.
23.00%
22.19%
22.73%
21.92%
22.46%
Original Debt/Equity Ratio = (1/3) / (2/3) = 0.50

New Debt/Equity Ratio = (2/3) / (1/3) = 2.0
rS = 15.0% = 5.0% + (12.0% - 5.00)*(L1)
L1 = (15.0% - 5.0%) / 7.0%) = 1.428571429
U = 1.428571429 / [1 + (0.50)(1-.40)] = 1.428571429 / 1.30 = 1.098901099
L2 = [1.098901099] * [1 + (2.0)(1-.40)] = 2.417582418
New rS = 5.0% + (12.0% - 5.0%)(2.417582418) = 21.92%
Page 36 of 42 Pages
48.
Assume that your firm has estimated that it will spend $20 million on new capital
budgeting projects during the coming year and that you have been asked to calculate
the appropriate cost of capital to be used to analyze these projects. You have
collected the following information:
common equity.
The company has corporate bonds outstanding with an 9 percent annual coupon that
are trading at par.
year (D1).
slight discount from the current price), and the firm will have to pay flotation expense of
10.0% ($2.75).
of the firm.
Given this information, determine what the WACC/MCC will be for the very first dollar
to be raised.
A.
B.
C.
D.
E.
9.28%
9.79%
9.45%
9.96%
9.62%
Since the firm expects to add $5,000,000 to its retained earnings account, the equity
portion for the very first dollar to be raised will come from retained earnings.
Therefore, we would have the following:
After-tax rD = (6%)(1-.40) = 5.4%
rS = 0.04 + (0.06)(1.5) = 13.0%
Alternatively,
g = (0.20)(1 - 0.73) = 5.4%
rS = $2.20 / $28.95 + 0.054 = 0.076 + 0.054 = 13.0%
re = $2.20 / ($27.50)(1-.10) + 0.054 = 0.089 + 0.054 = 14.30% (not needed)
Page 37 of 42 Pages
WACC = (5.4%)(0.40) + (13.0%)(0.60) = 2.16% + 7.8% = 9.96%
49.
Assume that investors in the stock of Company A have a required rate of return of 12
percent. The company has just paid a dividend of $1.50 (D0 = $1.50, which will grow
at the firms constant, long-run sustainable growth rate) and the stock has a current
price of $26.50. [HINT: you should now be able to determine the long-run sustainable
growth rate.] The companys investment bankers have told them that if they issue new
stock, they could issue it at the current market price of $26.50 per share, but that
flotation costs would be equal to $4.50 per share. Given this information, determine
the firms cost of newly issued equity (re).
A.
B.
C.
D.
E.
17.83%
16.68%
15.53%
14.38%
13.23%
P0 = (D0)*(1+g) / (rS - g)
$26.50 = ($1.50)*(1+g) / (.12 - g)
($26.50)*(.12 - g) = ($1.50)*(1+g)
Multiplying through:
$3.18 - $26.50g = $1.50 + $1.50g
($3.18 - $1.50) = ($1.50g + $26.50g)
$1.68 = $28.00g
g = $1.68 / $28.00 = 6.0%
D1 = ($1.50)*(1.06) = $1.59
PN = $26.50 - $4.50 = $22.00
re = (D1 / PN) + g
re = ($1.59 / $22.00) + 0.06 = 13.23%
50.
Assume that a firms targeted capital structure consists of 35 percent debt, 15 percent
preferred stock, and 50 percent common stock. Also assume that the current yield on
the firms debt is 9 percent, the cost of stock is 15 percent, the tax rate is 40 percent,
and the firms weighted average cost of capital (WACC) is 11.0175 percent. Given this
information, determine the firms after-tax cost of preferred stock (rP).
Page 38 of 42 Pages
A.
B.
C.
D.
E.
9.35%
9.85%
10.35%
10.85%
11.35%
WACC = .110175 = (.09)*(1-.4)*(.35) + (rP)*(.15) + (.15)*(.50)

rP = (0.110175 - 0.0189 - 0.075) / .15 = 10.85%
51.
Assume that investors in the stock of Company A have a required rate of return of 14
percent. The company has just paid a dividend of $1.50 (D0 = $1.50, which will grow
at the firms constant, long-run sustainable growth rate) and the stock has a current
price of $27.00. [HINT: you should now be able to determine the long-run sustainable
growth rate.] The companys investment bankers have told them that if they issue new
stock, they could issue it at the current market price of $27.00 per share, but that
flotation costs would be equal to $5.50 per share. Given this information, determine
the firms cost of newly issued equity (re).
A.
B.
C.
D.
E.
17.83%
16.68%
15.53%
14.38%
13.23%
P0 = (D0)*(1+g) / (rS - g)
$27.00 = ($1.50)*(1+g) / (.14 - g)
($27.00)*(.14 - g) = ($1.50)*(1+g)
Multiplying through:
$3.78 - $27.00g = $1.50 + $1.50g
($3.78 - $1.50) = ($1.50g + $27.00g)
$2.28 = $28.50g
g = $2.28 / $28.50 = 8.0%
D1 = ($1.50)*(1.08) = $1.62
PN = $27.00 - $5.50 = $21.50
re = (D1 / PN) + g
re = ($1.62 / $21.50) + 0.08 = 15.53%
Page 39 of 42 Pages
52.
Assume that a firms targeted capital structure consists of 35 percent debt, 15 percent
preferred stock, and 50 percent common stock. Also assume that the current yield on
the firms debt is 9 percent, the cost of stock is 15 percent, the tax rate is 40 percent,
and the firms weighted average cost of capital (WACC) is 10.9425 percent. Given this
information, determine the firms after-tax cost of preferred stock (rP).
A.
B.
C.
D.
E.
9.35%
9.85%
10.35%
10.85%
11.35%
WACC = .109425 = (.09)*(1-.4)*(.35) + (rP)*(.15) + (.15)*(.50)

rP = (0.109425 - 0.0189 - 0.075) / .15 = 10.35%
53.
Assume that you have collected the following information regarding your company:

The companys forecasted capital budget for the coming year is $12,000,000.
bonds are selling at par value you may ignore flotation costs.
a year.
The company anticipates that it will add $4,500,000 to its retained earnings
account over the coming year, but that it will also need to raise new common
stock over the year. Its investment bankers anticipate that the total flotation
cost for new common stock will equal 12.50 percent of the amount issued (or
price per share) -- you may assume that the company accounts for flotation
costs by adjusting the component cost of capital (i.e., it determines a price that
it will net and then uses a DCF approach to determine re).
Given this information, determine what the companys average cost of capital will be
for the entire $12,000 to be raised.
A.
B.
C.
D.
E.
10.33%
8.68%
9.78%
10.88%
9.23%
rd = 7% (given)
AT rD = (7%)*(1-.4) = 4.2%
rS = [D1 / P0] + g
Page 40 of 42 Pages
rS = [$1.25 / $20] + 0.06 = 12.25%

re = [D1 / P0(1 - F)] + g
re = [$1.25 / $20(1 - 0.125)] + 0.06 = 13.14%
Amount to be Raised:
Debt = ($12,000,000)*(.40) = $4,800,000
Retained Earnings = $4,500,000 (Given)
New Equity = ($12,000,000)*(.60) - $4,500,000 = $2,700,000
Weights of Total to be Raised:
Debt = $4,800,000 / $12,000,000 = 40%
Retained Earnings = $4,500,000 / $12,000,000 = 37.50%
New Equity = $2,700,000 / $12,000,000 = 22.50%
Average Cost = (4.2%)*(.40) + (12.25%)*(.375) + (13.14%)*(.225)
Average Cost = 1.68% + 4.59375% + 2.9565% = 9.27025% = 9.23%
54.
Assume that you have collected the following information regarding your company:

The companys forecasted capital budget for the coming year is $15,000,000.
bonds are selling at par value you may ignore flotation costs.
a year.
The company anticipates that it will add $4,500,000 to its retained earnings
account over the coming year, but that it will also need to raise new common
stock over the year. Its investment bankers anticipate that the total flotation
cost for new common stock will equal 12.50 percent of the amount issued (or
price per share) -- you may assume that the company accounts for flotation
costs by adjusting the component cost of capital (i.e., it determines a price that
it will net and then uses a DCF approach to determine re).
Given this information, determine what the companys average cost of capital will be
for the entire $12,000 to be raised.
A.
B.
C.
D.
E.
10.33%
8.68%
9.78%
10.88%
9.23%
Page 41 of 42 Pages
rd = 9% (given)
AT rD = (9%)*(1-.4) = 5.4%
rS = [D1 / P0] + g
rS = [$1.25 / $20] + 0.06 = 12.25%
re = [D1 / P0(1 - F)] + g
re = [$1.25 / $20(1 - 0.125)] + 0.06 = 13.14%
Amount to be Raised:
Debt = ($15,000,000)*(.40) = $6,000,000
Retained Earnings = $4,500,000 (Given)
New Equity = ($15,000,000)*(.60) - $4,500,000 = $4,500,000
Weights of Total to be Raised:
Debt = $6,000,000 / $15,000,000 = 40%
Retained Earnings = $4,500,000 / $15,000,000 = 30.00%
New Equity = $4,500,000 / $15,000,000 = 30.00%
Average Cost = (5.4%)*(.40) + (12.25%)*(.30) + (13.14%)*(.30)
Average Cost = 2.16% + 3.675% + 3.942% = 9.337% = 9.78%
Page 42 of 42 Pages

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Cost of Capital - Solutions

Old Exam Questions - Cost of Capital - Solutions

Which of the following statements is not (or least) correct?

Because of the tax shelter created by issuing preferred stock dividends

Old Exam Questions - Cost of Capital - Solutions

Riskier over time, and its value will decline.

Increase the IRR of the asset to reflect the greater risk.

Select the statement that is most correct.

Old Exam Questions - Cost of Capital - Solutions

Select the statement that is most correct.

Which of the following statements is most correct?

Which of the following statements is most correct?

Old Exam Questions - Cost of Capital - Solutions

Which of the following statements is correct (most correct)?

Select the statement that is most correct.

Old Exam Questions - Cost of Capital - Solutions

WACC = (.05)(1-.4)(30%) + (.10)(70%) = .009 + .07 = 7.9%

What is the WACC of the entire $10 million to be raised?

Debt = ($10,000,000)(.40) = $4,000,000

After-tax KD = (8%)(1-.40) = 4.8%

Old Exam Questions - Cost of Capital - Solutions

KS = 0.04 + (0.05)(1.2) = 10%

Net Price = ($980) (1 - .02) = $960.40

Old Exam Questions - Cost of Capital - Solutions

5% for the first $500,000 of new debt.

8% for the first $500,000 of new preferred.

12% for retained earnings.

After-tax Costs of Debt: 3.0%, 3.6%, and 4.2%

RE = ($550,000 - $50,000)(1-.4) = $300,000

Old Exam Questions - Cost of Capital - Solutions

There are several different ways to do this. One of them is below.

A firms optimal capital structure consists of 40 percent debt, 10 percent preferred

WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS)

WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS)

Old Exam Questions - Cost of Capital - Solutions

What is the WACC of the entire $9 million to be raised?

Debt = ($9,000,000)(.35) = $3,150,000

After-tax KD = (6%)(1-.40) = 3.6%

Old Exam Questions - Cost of Capital - Solutions

WACC = (3.6%)(0.35) + (10.0%)(0.30) + (10.71%)(0.35)

WACC = (KD)(1-T)(WD) + (KP)(WP) + (KS)(WS)

4% for the first $2,000,000 of new debt.

6% for the first $1,000,000 of new preferred.

10% for retained earnings.

Old Exam Questions - Cost of Capital - Solutions

11% for up to the first $2,000,000 of new common stock.

Debt = (.30)($10,000,000) = $3,000,000

Additions to Retained Earnings = ($1,000,000 - $100,000)(1 - .4) = $540,000

Old Exam Questions - Cost of Capital - Solutions

Ke = D1/(P0 - F) + g = $4.00/($50 - $7) + 6% = $4.00/$43 + 6% = 9.30% + 6% =

Determine the companys WACC.

N = 18, PV = -1,120, PMT = 75, FV = 1000, Solve for I/YR = KD = 6.36145%

Debt = ($8,000,000)(.40) = $3,200,000

After-tax KD = (7%)(1-.40) = 4.2%

Old Exam Questions - Cost of Capital - Solutions

KS = 0.02 + (0.06)(1.5) = 11%

WACC = [(0.45)(KD)(1 - T)] + [(0.55)(KS)]

Use bond information to solve for KD:

Old Exam Questions - Cost of Capital - Solutions

Plug these values into the WACC equation and solve:

Old Exam Questions - Cost of Capital - Solutions

P0 = [($1.00)(1.15)] / [.20 - .15] = $23.00

WACC = (.08)(1-.4)(.4) + (.15)*(.6) = 1.92% + 9.0% = 10.92 percent

WACC = .110175 = (.09)(1-.4)(.35) + (rP)(.15) + (.15)(.50)

WACC = .109425 = (.09)(1-.4)(.35) + (rP)(.15) + (.15)(.50)